Context:
Leading financial services firm Motilal Oswal Financial Services will bar its clients from taking intraday short-selling position on stocks that are not part of the futures and options (F&O) segment. Motilal Oswal Financial Services, with 10.3 lakh clients at the end of January, is the first large brokerage to undertake such a move at a time when the markets have been battered for five straight months.
Futures and Options (F&O) Trading
Futures and Options (F&Os) are derivatives which can be traded in financial markets for all and sundry. They are primarily used to hedge risk, speculate outcomes, and diversify portfolios.
Futures Contracts
- Definition
- An agreement legally binding between two parties in contract to buy or sell an asset (stocks, commodities, indices, or currencies) at a predetermined price, at a specific future date.
- Obligation
- Buyer and seller must fulfill the contract. It applies in the event where there exist movements in the market price.
- Profit & Loss
- If the market price rises above the agreed price, the buyer profits while the seller incurs a loss.
- The seller profits and the buyer incurs loss if the market price tumbles.
- Use Cases
- Traders and institutions use it frequently for hedging against price fluctuations or speculating about their possible price changes in the future.
Options Contracts
- Definition
- The contract refers to a financial contract which entitles the buyer, but does not obligate the buyer, to the right to buy (Call Option) or sell (Put Option) an asset at a predetermined price before or on expiration of the contract.
- Types of Options
- Call Option: Grants the bearer the right to purchase the asset at a set price. Profitable when the market price is higher.
- Put Option: Grants the bearer the right to sell the asset at a set price. Profitable when the market price is lower.
- Risk & Reward
- Losses incurred by a buyer are maximally equal to the price of the option. However, profits can be very high when the market moves favorably.
- The seller or writer of the option can incur losses that may be of unlimited possible amounts.
- They Use This For
- Hedging against price risk, sources of income, as well as tactical trading methods.
Major Differences between Futures and Options
| Feature | Futures | Options |
|---|---|---|
| Obligation | Buyer and seller must execute contract | Buyer has a choice; seller is obligated if exercised |
| Risk | Unlimited for both parties | Limited for buyer, unlimited for seller |
| Profit Potential | Depends on price movement | Buyer’s profit depends on market movement, seller gains limited to premium |
| Flexibility | No flexibility; must settle at expiry | High flexibility; can expire worthless or be exercised |
| Cost | No upfront premium, margin required | Buyer pays a premium, which is the maximum loss |
Benefits and Risks Associated with F&O Trading
- Benefits
- Leverage increases the sensitivity ratio, allowing owners to expose larger amounts of money without raising their liability.
- Hedged against adverse price movements.
- Highly liquid in major financial markets.
- Risks
- Very high volatility may lead to severe losses.
- Understanding high market and having a strategized plan are required before making an entry.
- Margin calls in futures trading often mean financial distress.
